This is a research-based article dealing with various aspects of Islamic finance and its wider application in today’s banking environment. The article has been divided in five parts; part-II will be published in the next issue of B&FR and each subsequent issues will
carry the remaining parts
By Dr Shahid Hasan Siddiqui
Riba is prohibited in Islam in all forms and manifestations. This prohibition, which is based on the Divine Authority and not on an economic theory, is strict, absolute and unambiguous. The holy Qur’an says “O ye who believe! Fear Allah and give up what remains of your demand for riba; if you are indeed believers” (2:278). The next verse says “If you do it not, take notice of war from Allah and His Messenger. But if ye turn back, ye shall have your capital sums. Deal not unjustly and you shall not be dealt with unjustly.” (2:279). In the light of these guidelines, riba can be defined as “Any amount, big or small, over the principal, in a contract of loan or debt is Riba, prohibited by the Holy Qur’an regardless of whether the loan is taken for the purpose of consumption or for some productive activity.”
It is important to note that in money lending transactions, any thing recovered, paid or received, in excess of the principal amount, as per agreed arrangements is riba. It does not make any difference by whatever name it is called, riba, usury, interest, profit, biyaj, mark-up or service charge etc. It must also be clearly understood that riba is prohibited as it may lead to injustices (zulm) and Islam is against all forms of injustices and exploitations and pleads an economic system that aims to secure extensive, socio-economic justice. It therefore, follows that any system designed and adopted under the banner of Islamic banking system, as an alternate of interest-based banking system, must have the following three ingredients:
(i) It must not contain any element of riba usury or interest, by whatever name it is called.
(ii) It must remove the injustices of the interest-based system in all spheres of operations.
(iii) It must contribute to the achievement of the socio-economic objectives of the Islamic economic system.
There is consensus among Islamic scholars that to replace interest, the ideal mode of financing under Islamic banking system is financing on profit and loss sharing (PLS) basis. It therefore, follows that in case an entrepreneur availing finance from an Islamic bank earns profit, it must be shared between the bank and the entrepreneur. The Islamic bank, on the other hand, must share its profit with depositors/ investors. This would ensure justice between all the stake-holders namely, depositors/ investors, entrepreneurs availing finance from the bank and the bank itself.
While designing modes of financing under Islamic banking system, it soon became clear that large scale resorting to PLS system would pose serious risks and hazards to Islamic banks in many Islamic countries due to wide-spread tendency to adopt unethical accounting practices to conceal true profits, high rate of illiteracy and host of other reasons. It was therefore, considered necessary to devise various other modes of financing in addition to musharakah and mudarabah based on PLS system and of course, Qard-e-Hasan. It was however, initially laid down that some other modes of financing based on second-line pre-determined fixed rate of return techniques should also be designed for Islamic banks for transitory period with the proviso that gradual shift to PLS system will take place.
The two parallel systems
Although interest-based banks and Islamic banks are now operating parallel to each other in many Muslim countries but the interest-based banks are obviously the market leaders and probably will remain so for a long time though Islamic banks and Islamic windows are fast spreading in many Muslim and non-Muslim countries.
There is, however, no denying of the fact that under the interest-based system of banking or in a system not strictly based on the principles and spirit of Shariah, depositors as well as borrowers are being exploited in one form or the other. It is however, significant to note that, as in the case of conventional banking, the depositors are being exploited most by banks and financial institutions operating in many Muslim countries under the banner of Islamic banking. The main reason for this is that Islamic banks are following the bench-marks of interest-based system.
The fact of the matter however, is that Islamic banks, in the present circumstances can not, even if they want to, possibly eliminate the injustices melted out to depositors / investors by the interest-based banks. For payment of real positive rates of return (rates of return less rate of inflation) Islamic banks, in most cases, in addition to reducing their spreads, would have to first enhance rates of return on their financings. This enhancement would not be acceptable to many entrepreneurs availing finance from Islamic banks as alternate avenues are available to them for securing advances at lower rates of interest from conventional banks.
It is therefore, crystal clear that the policy adopted by Central Banks of most Islamic countries to allow, for an indefinite or unduly long periods, the conventional and Islamic banks to run parallel to each other is not correct and is giving bad name to the Islamic system of banking notwithstanding that the fault lies with us and not with the system.
The objective of elimination of the injustices of the interest-based system cannot be achieved if the Islamic banks and conventional banks in Muslim countries continue to operate parallel to each other. These injustices can however, be eliminated to some extent if Islamic banks become market leaders even in the parallel system. This would be possible only when the market share of Islamic banks in a Muslim country is raised to about 50 percent of the total volume of the banking sector in that country. This does not seem to be a possibility even in the next decade in most Islamic countries unless of course, these countries change their existing policies and strategies. The Governor of Central Bank of Pakistan has recently emphasised that Islamic banks in Pakistan will need to grow at least by 40 – 50 percent annually to be able to raise it’s share from the present 3.5 percent to 15 percent.
Modes of financing
The modes of financing in an Islamic frame-work can be divided into following four main categories:
(b) Shirkah based/profit/loss sharing modes
(c) Debt-creating modes:
(i) Financing by way of trade
(ii) Financing by way of lease
(d) Service / agency based modes
These categories are briefly discussed as under:
Lending has to be a virtuous act as per the principles of Shariah. The principle that holy Qur’an has given in Verses 2:278 and 2:279 is that in both cases of loans and debts the creditor has the right to the principal amount only; in former case, exactly the amount given as loan, and in latter case, the amount of debt generated from the credit transactions etc. At the most, they can recover from the debtors a service charge not exceeding the actual proportionate cost of the operations, excluding the cost of funds or opportunity cost in the conventional sense. As Islamic banks are commercial organisations, lending is not their major activity.
(b) Shirkah-based / PLS modes
Shirkah can be defined as an arrangement where two or more persons combine either their capital or labour or credit-worthiness together, having similar rights and liabilities, to share the profits or a yield or appreciation in value and to share the loss, if any, according to their proportionate ownership.
Shirkah can be divided into two broad types of Shirkatul Milk (partnership through ownership) and Shirkatul Aqd (through contract) with Shirkatul ‘Inan. The latter, that is more relevant to the general partnership business and generally termed as commercial partnership, is divided into further three types i.e. Shirkah al Amwal (Capital), Shirkah al A‘amal (work) and Shirkah al Wajooh (based on credit worthiness).
Shirkatul Milk is the mixing of ownership mandatory or by choice. It is not for any commercial business or sharing of profit. The co-owners may use the property jointly or individually or share in its appreciation / depreciation when disposed off. If joint property is used by one partner, other partner may demand rent for his part of the property. The distribution of the revenue of Shirkatul Milk is always subject to the proportion of ownership.
Shirkatul ‘Inan is a valid form of contractual partnership in the eyes of all schools of thought. It means a joint enterprise formed for conducting any business with the condition that all partners shall share the profit according to agreed ratio while the loss will be borne according to the ratio of contribution to the joint business. Each partner is an agent to other partners. It is most suitable for joint businesses, adaptable to any situation and applicable in the present day’s commercial practices. Normally every partner can take part in management of the partnership business but it is not necessary that all partners take part in management/work; any one of them may opt not to work. They may distribute among themselves their responsibilities, duties and jobs by a mutual agreement. Below we discuss the commonly used terms of musharakah and mudarabah.
Musharakah is a term used by the contemporary scholars which technically means a contractual relationship established under a contract by the mutual consent of the parties for sharing of profits and losses arising from a joint enterprise or venture. The partners may contribute funds, not necessarily equally according to the arrangements covered under Shirkatul ‘Inan. Capital to be invested by the partners can be unequal but may be in the form of equal units representing currency called shares and the intended partners may buy these shares disproportionately. All assets of musharakah are jointly owned in proportion to the contribution of each partner.
Profit can be divisible unequally and un-proportionate to the capital invested – the ratio of profit distribution may differ from ratio of investment in the total capital, but the loss must be borne exactly in accordance with the ratio of capital invested by each of the partners. If one or more partners choose to become non-working or sleeping partners, the ratio of their profit cannot exceed the ratio which their capital investment bears to the total capital. It is not allowed to fix a lump sum amount for any of the partners, or any rate of profit tied up with his investment.
A partner in a commercial partnership cannot guarantee the capital of the other partners. Any third party that is independent from the musharakah can guarantee to make up loss of the capital, but the guarantee should neither be provided for any consideration nor linked in any manner to the musharakah contract. In the case of musharakah agreements with clients, banks can obtain a pledge of security or guarantee to ensure safety and proper handling of the joint assets and business. Such security can be utilised in case the damage or loss to the principal amount/profit was due to sheer negligence or unwillingness of the client.
The musharakah mode of financing based mainly on the above basis is being used by Islamic banks. Profit projections can play an important role in the musharakah operations. The client can be required to provide periodically the results of operations of the business to the bank. Scholars have approved the concept of ‘projected profit’ subject to final settlement at the end of the term, meaning that any amount so drawn by any partner shall be treated as ‘on account payment’ and will be adjusted against the actual profit due to each partner at the end of the term. The disputes can be resolved through a ‘Review Committee’ comprising of persons to be named in the musharakah agreement with mutual understanding of the parties.
While there is unanimity of thought amongst Muslim jurists that losses are to be shared by the parties according to the ratio of their capital, there is however, difference of opinion among Muslim jurists on the issue of the ratios of the profit to be shared. According to Imam Malik and Imam Shafi’i, the profits must be shared exactly in the ratio of capital provided by the partners.
The view of Imam Ahmad bin Hanbal is that the ratio of profit can be fixed by mutual consent of the parties and could, therefore, differ from the ratio of capital employed in the project. Imam Abu Hanifah’s school of thought is that the ratio of profit may differ from the ratio of capital injected in the project. If however, a partner puts an explicit condition that he would remain a sleeping partner throughout the term of musharakah, his share of profit cannot be more than the share of his investment.
Courtesy: The News, 21/4/2008